Dec 13. Yields are high because they AREN’T liquid

It was a volatile end of the week. VIX settled at its highest level since the end of September at 24.39. Stocks tumbled Friday with SPX down 3.8% on the week and the Russell down 5%. In a sign of EM fragility, the Mexican Peso closed at a record low, and the Chinese yuan also hit a new recent low. High yield ETFs were crushed to the lowest levels since 2009 when we were pulling out of the worst of the crisis. I have mentioned deterioration in high yield many times, but the fabric continues to fray. On Dec 10, Third Avenue Focused Credit closed, “…and placed the fund’s remaining assets into a liquidating trust. The trust will make distributions to the fund’s shareholders as income is received and assets are sold. Third Avenue expects the liquidation to take up to a year or more to complete.” Then on Friday, Stone Lion Capital, a distressed bond fund, suspended redemptions due to, well, requests for redemptions. My old friend Larry had a classic line for this type of a situation, “I don’t want the cheese anymore, just help me get my head out of this trap.” Investors are starting to squeeze through a small exit door. The Morningstar article from which I quoted above starts with this headline:   “The demise of Third Avenue represents a profound management failure, but it isn’t likely that we’ll see other high-yield funds follow suit.” (Except for two days later). Apparently the “profound failure” was that the fund invested in illiquid bonds. Yup, that’s what the article says. But then was unable to easily unload them. That’s some fine investigative work there, Lou. And it goes on to note. “As we approach a likely Fed rate hike next week and the holidays, market liquidity could well take a hit.” Hmmm, you don’t say. I’m glad Morningstar thinks that contagion isn’t likely, though I’d feel much better if I heard it from someone higher up, say, at the Fed. Because when the Fed says something is contained, well….you know the rest. By the way, in the 2008 meltdown the problem was mortgages, and the Federal Gov’t became the mortgage market. This time it’s much different. Is the gov’t going to step in and support corporate debt?

Early in the year, when the market was debating the idea of a September or December hike, I recall one analyst specifically saying the Fed should go in Sept rather than tighten at an illiquid time, year end. That would have been prudent. However, now we’re faced with a hike this week. The short end has priced it in; in my opinion it would be folly to hold off now. The challenge is for the Fed to slow expectations on trajectory without belying concerns about the economy falling into a negative spiral.

I’ve read many notes about the Dodd Frank rule changes that have caused dealers to pull back on inventory, and generally have contributed to technical pricing anomalies (Negative swap spreads, etc). I really am not familiar enough with the regulatory minutia to form an opinion on ultimate outcomes. What I do understand is this: QE was designed to make market participants take more risk and compress spreads down to unreasonable levels, so that companies would take cheap financing and invest in new jobs-producing projects. The investing turned out to be mostly financial. The withdrawal of QE has reversed this process over time, unwinding the artificially pricing of debt, and high pricing of risk assets. At the same time, in the big picture, the regulatory environment has served to push things in the same direction, that is, the Fed is withdrawing support for risk while the regulators have warned big banks to shun taking risk. And now the Fed is further tightening money market conditions.   When’s the last straw? One can look at the financial stress charts attached and say that conditions aren’t yet problematic. And that might be right, but Bear was in 2007 and the Goldman financial conditions index didn’t really surge until mid-2008. In other words, it didn’t exactly provide the tsunami warning. In fact it might be Cleveland that indicates the most foreshadowing.

fin conditions

(White line is Chicago National Financial Conditions, Gold is GS Financial Conditions, Green is St Louis and Pink is Cleveland Fed Financial stress).

On the week the Eurodollar spreads declined.   The peak one year spreads are EDH16/EDH17 and EDM17/EDM18 and they’re both just 56.5, indicating around two hikes per year. March’16/17 declined 7 bps on the week.

Many analysts are suggesting that the dots will play a big role in how the Fed provides forward guidance. Kocherlakota won’t be participating, so hopefully that will eliminate the negative dot. The dots for year end 2016 (mean) have progressed over time as follows: In March, the 17 dot mean fell nearly 52 bps to 2.02%. In June it fell another 27 to 1.75%. In September another 27 to 1.48%, and now it has to come down again. EDZ’16 is currently 98.92 or 1.08%, consistent with funds under 1%. I wouldn’t be surprised to see the 2016 mean come down to 1.25%. I really don’t think the dots provide any value at all, except for providing clear evidence that the Fed follows the market, with a lag.

What I did on the attached table is to look at the quarterly contracts starting six months after the FOMC meetings, and specifically look at the two year spreads, white to green and red to blue. I don’t draw heavy conclusions from this except to note that we are going into the Fed with the six month forward contract, currently EDM6, at 9921.5, at the lowest level of any six month forward contract so far. Not too surprising, the Fed has told us they’re going to hike. However, white to green and red to blue spreads are also the flattest they’ve been, both before and right after the meeting. These spreads are indicating a market that is at best skeptical of the Fed’s ability to engender inflation. EDM16/EDM18 is currently just 99.5. The same relative spread was 118 at the last quarterly FOMC and 153.5 the time before that. EDM17/EDM19 is just 73 bps and was 97.5 in the previous qtr and 108 the qtr before that.  On a longer time frame basis, I think back spreads like EDM17/19 is too cheap here, especially if the Fed signals “one and done.”


Sometimes it’s just this simple (as described by Billy Ray Valentine in Trading Places). “Hey, we’re losing all our damn money, and Christmas is around the corner, and I ain’t gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain’t gonna f… my wife ain’t gonna make love to me if I got no money!” So they’re panicking right now, they’re screaming “SELL! SELL!” to get out before the price keeps dropping. They panickin’ out there right now, I can feel it.


12/4/2015 12/11/2015 chg
UST 2Y 94.3 89.1 -5.2
UST 5Y 171.0 156.9 -14.1
UST 10Y 228.0 213.8 -14.2
UST 30Y 301.0 287.9 -13.1
GERM 2Y -30.3 -35.1 -4.8
GERM 10Y 67.8 54.0 -13.8
EURO$ H6/H7 63.5 56.5 -7.0
EURO$ H7/H8 50.0 47.5 -2.5
EUR 108.85 109.91 1.06
CRUDE (1st cont) 39.97 35.62 -4.35
SPX 2091.69 2012.37 -79.32
VIX 14.81 24.39 9.58
Posted on December 13, 2015 at 12:38 pm by alexmanzara · Permalink
In: Eurodollar Options

Leave a Reply